Decommissioning Cost Allocation Methods & Alternative Financial Assurance

Decommissioning Cost Allocation Methods & Alternatives Financial Assurance

Benny Lubiantara

Presented in Decommissioning Forum, Surabaya, 2004

Presentation Overview

• Decommissioning Cost Allocation Methods

• Alternatives Financial Assurance

• Example of Field Experience

Decommissioning Cost Allocation Methods

Worldwide Fiscal Provision for Abandonment

• Carry Back• Amortised over Field Life• Unit of Production• Expensed • Tax Credit

Carry Back

• For tax purposes, abandonment costs are carried back fora maximum period and offset against income.

• The taxable income in those years sets a limit on the taxrelief for abandonment which can be obtained, A taxrebate would be obtained in the year of abandonment.

• Carry back method are incorporated in the fiscal terms ofthe UK, Ireland, New Zealand and the Falkland Islands.

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996

Carry Back Decommissioning

Cost

Amortised over Field Life

• After the Government has approved an estimateof the cost of Abandonment, the cost areamortised over the remaining field life with thecontractor depositing the amortised amountsinto an abandonment fund.

• The deposits are then recoverable from revenuegenerated from production under cost recoveryprovisions.

Amortised over Field Life


Unit of Production

• Similar to amortised over field life method,under units of production systems, estimatedabandonment costs are deposited into anabandonment fund and recovered on a units ofproduction basis over the final years of theproject.

• Countries which have incorporated suchprovisions in their Fiscal terms: Venezuela,Angola and the Netherlands.

Unit of Production


Expensed

• The costs of field abandonment are expensed inthe year they are incurred and written offagainst income from the field or from othersources.

• The cost of abandonment effectively creates atax credit or tax deduction in the final year ofthe project.

• Countries which have incorporated suchprovisions in their Fiscal terms: Thailand,Tanzania, Romania

Expensed


Tax Credit

• Tax credit is given on excess abandonment costfor the year in which abandonment occurs.Abandonment cost can be expensed in the yearit occurs to a maximum of the taxable incomefor that year.

• After the abandonment process has occurred,the abandonment cost is deducted in the lastyear with the excess abandonment cost gaininga tax credit of 40 percent. The maximumallowable to be deducted in the last year isequal to the taxable income in this year.

In the example only US$5 million can be deducted in the last year. Although US$ 20 million was spent on abandonment, the net revenue in the last year is only US$5 million. The remaining US$15 million will be given a tax credit as shown:Tax Credit = (Abandonment cost - last year taxable income)*40%

Tax Credit


Economic Effect of Fiscal Provision for Abandonment

• Carry Back - NPV @ 15% = 71.10 MM$

• Amortised - NPV @ 15% = 63.58 MM$

• Unit of Production - NPV @ 15% = 64.86 MM$

• Expensed - NPV @ 15% = 64.78 MM$

• Tax Credit - NPV @ 15% = 67.77 MM$

In order to compare the economic effect, The Net Present Value (NPV) is used – The cash flow is discounted at 15%

Economic Effect of Fiscal Provision for Abandonment

• Carry Back - NPV @ 15% = 71.10 MM$

• Amortised - NPV @ 15% = 63.58 MM$

• Unit of Production - NPV @ 15% = 64.86 MM$

• Expensed - NPV @ 15% = 64.78 MM$

• Tax Credit - NPV @ 15% = 67.77 MM$

In order to compare the economic effect, The Net Present Value (NPV) is used – The cash flow is discounted at 15%

Alternatives Financial Assurance

Financial Assurance mechanisms may be placed in two basic categories:

• Funds are actually set aside(Escrows Account, Trusts Fund, and deposits with the Regulatory Authority).

• Financial guarantees(surety bonds, Bank Guarantte, letters of credit, and insurance).

Funds “set-aside”

Trust Fund -

is an arrangement in which a separate legal

entity, the trustee, is created by the oil

company to hold assets or funds for the

purpose of decommissioning works.


Deposit with the Regulatory Authority

A deposit of cash , certificate of deposit with the

Regulatory Authority for decommissioning

works.


Escrow account -Cash is placed in a bank account by the Oil Company under an escrow agreement between the oil company, the bank, and the Regulatory Authority, An escrow agreement specify that the Regulatory Authority has full control over the account until it is released when the decommissioning work has commenced.

Financial Guarantee

Surety BondSurety company writes a surety bond, it guarantees that the oil

company will perform all operations related to the

decommissioning works. Otherwise, the Surety Company will pay

the bond sum to the regulatory authority, which will pay a private

contractor to perform the decommissioning.

Surety bonds are similar to insurance policies in that oil companies

pay annual premiums to keep the surety bonds in place.

Financial Guarantee

Insurance - An applicant takes out a closure insurance policy from an insurance company. The policy must be issued in an amount adequate to cover the decommissioning costs. The Regulatory Authority is the beneficiary of the policy.

Letter of Credit - This is similar to a bond with a bank or financial institution taking the place of a surety. A irrevocable letter of credit is established solely for the purpose of guaranteeing performance of obligations under a reclamation permit. The bank or financial institution bank agrees to pay in event of default.

Why Financial Guarantee needed ?

Because there is no guarantee that enough funding are available at the end of the project.

Field Experience :

Cook Inlet Alaska Oil & Gas Facilities

Source : Van Dyke & Daniel Zobrist,

“Funding For Abandonment of Cook Inlet Alaska Oil and Gas Facilities: A Landowner's Perspective”, SPE 68853, 2001

• The abandonment funding agreement is intended to balance the

Regulatory Authority’s need for risk mitigation while keeping

the oil company incentive for incremental investment.

• It recognizes the collateral value of oil and gas in the ground but

includes supplemental bonding, and stand-alone escrow funding

when the collateral slips below a specified cushion.

Abandonment Funding Agreement

Bonding

Until abandonment obligations are complete, an

annually renewed surety bond is provided to the

Regulatory Authority. This is intended to remove the

risk to the Regulatory Authority of immediately

raising cash to maintain and operate the offshore

platforms in case of bankruptcy by the oil company.

Proved Reserves

• The existence of proved reserves serve as collateral to the

Regulatory Authority. By recognizing this asset, the Regulatory

Authority avoids unnecessarily burdening the oil company with

costly guarantees that mitigate risks that may not exist at the

time.

• The oil company prepares an annual Proved Reserves Report to

record changes in reserve value, as oil and gas forecasts change

and production occurs. The Proved Reserves Report is subject

to audit and the selection of price, cost and discount rate is

stipulated in the Agreement.

Escrow Account

• An Escrow Account is established to pay for the actual costs to abandon the facilities.

• Payments into the Account begin only when the value of the oil and gas reserves have dropped to a level insufficient (in the view of the Regulatory Authority) to act as collateral for the cost of abandonment of the platforms.

• The uncertainty of the actual cost of abandonment make the Regulatory Authority to require a 150% cushion of collateral.

Escrow Account

• The oil company begins making payments into the Fund when the NPV of the net proved reserves is less than 150% of the NPV of the estimated abandonment costs.

• The amount of the payment into the fund each year is the difference between 150 percent of the NPV of the estimated abandonment costs and the sum of the Fund and NPV value of the reserves.

• No payment is necessary when the balance of the fund equals or exceeds the amount of the estimated abandonment costs.

• The monies in the Escrow Account are released to reimburse the oil company for abandonment expenditures when abandonment operations have commenced.

Case Illustration:

• Discount rate = 15% (for NPV calculation)

• Abandonment cost $31MM in 2009

• The principle of the fund is assumed to grow at an

annual rate of 5%

• Initial payment begins when the sum of the NPV of

the Fund and Proved Reserves < 150% of the PV of

the abandonment cost.

Assumptions:

Spreadsheet calculations

Source : Van Dyke & Daniel Zobrist,

“Funding For Abandonment of Cook Inlet Alaska Oil and Gas Facilities: A Landowner's Perspective”, SPE 68853, 2001

Documents

Decommissioning Cost Allocation Methods & Alternative Financial Assurance